John Hussman: A Pandora's Box of Potential Market Troubles

Excerpt from the Hussman Funds' Weekly Market Comment on the U.S. market (1/7/07):

Investors should evaluate their risk exposures and tolerances now, in order to allow for substantial further market weakness. Market conditions presently feature a Pandora's Box of rich valuations, vulnerable profit margins, rising default risk, rapidly deteriorating market internals, failing support levels, and accumulating evidence of oncoming recession. As I noted in my December 17 comment, "there is one particular scenario that would be ominous in my view. That would be if we see a relatively uninterrupted series of declines that breaks cleanly through the August and November lows, followed by a one-day advance of 200-400 Dow points. That's a script that markets tend to follow pre-crash."

Among various stock indices, the Value Line Composite and the equal-weighted S&P 500 indices broke cleanly through the August and November lows last week... On the basis of weekly closing values (which we generally ascribe more weight), even the S&P 500 and Dow Industrials broke their prior lows.

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On the mortgage front, it is important to reiterate that the swell in mortgage refinancings only began in October, and will continue well into 2009. Though Treasury yields have plunged, market lending rates such as LIBOR, commercial paper, BAA rates and so forth have been much stickier, so it is not at all clear that the rush to the safety of Treasuries (and the inevitable willingness of the Fed to align the Fed Funds rate lower in response) will result in meaningfully lower refinancing burdens. In the typical foreclosure event, there is first a burdensome reset, followed by several months of attempted payments, followed by several months of delinquency, and only then by foreclosure action. Given that the heavy resets only started in October, we are still about two or three quarters away from the really serious credit losses, foreclosures and writedowns.

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On the economic front, as I noted in November, the data already indicate the likelihood of a U.S. recession. Last week's poor ISM and employment reports add further confirmation to this expectation...

In short, if the potential negatives such as profit margin contraction and credit problems turn out to be only passing, minor events, then it might be true that the market has fully discounted them... However, my impression is that the scope of these problems is likely to be much broader than anticipated at present, and that the combination of worsening outcomes and a growing consensus could result in substantially more weakness than we've observed thus far.

Hussman returned to the Fed's recent conduct, and the oft exaggerated "liquidity injection".

With regard to the 'news' that the Federal Reserve will conduct $60 billion in term repos during January, note that $30 billion of those will be auctioned on Monday January 14, settling on Thursday January 17. The other $30 billion will be auctioned on Monday January 28, settling on Thursday January 31...

The belief that these 'injections' represent new money is a testament to the unwillingness of Wall Street to look at data. Recall one of my previous observations from December: "As a side note, we can already predict that at least one of the 'term auction' repos that will be announced in January will have a settlement date of January 17. Why? That's when the first term repo expires." It should be no surprise that the other term-auction repo the Fed initiated in December will mature on (you guessed it) January 31.

That said, I should note that discount window borrowings have increased to nearly $6 billion. While this is virtually nothing in relation to a $12.7 trillion banking system, it does represent the largest level of discount window borrowings since 2001. To some extent, then, the Fed can't be criticized for its efforts: it's doing more than it typically does...

What does seem clear is that the FOMC will be cutting its rate targets. Based on normal spreads between the Federal Funds rate and nearly all other market rates including both Treasury and corporate yields, as well as clear evidence of economic weakness, it's probable that the Fed Funds rate will be lowered to about 3% in the coming year.

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To the extent that Fed meetings occur in the perimeter of oversold conditions, the consistent knee-jerk exuberance of investors in response to Fed cuts may allow us some modest speculative opportunities by, say, briefly covering some of our short call options and then selling them out on rallies. But unless we observe more compelling evidence from valuations or market action, I certainly don't intend to remove put option defenses in anticipation of likely Fed cuts.